A False Sense of Security in Applying Handpicked Equations for Stress Test Purposes

30 Pages Posted: 23 Sep 2015

See all articles by Marco Gross

Marco Gross

International Monetary Fund (IMF); European Central Bank (ECB)

Francisco Javier Población García

European Central Bank (ECB)

Date Written: September 22, 2015

Abstract

The purpose of this paper is to promote the use of Bayesian model averaging for the design of satellite models that financial institutions employ for stress testing. Banks employing 'handpicked' equations – while meeting standard economic and econometric soundness criteria – risk significantly underestimating the response of risk parameters and therefore overestimating their capital absorption capacity. We present a set of credit risk models for 18 EU countries based both on the model averaging scheme as well as a series of handpicked equations and apply them to a sample of 108 SSM banks. We thereby aim to illustrate that the handpicked equations may indeed imply significantly lower default flow estimates and therefore overoptimistic estimates for the banks’ capital absorption capacity. The model averaging scheme that we promote should mitigate that risk and also help establish a level playing field with regard to a common level of conservatism across banks.

Keywords: Stress testing, satellite modeling, model averaging, bank regulation and supervision

JEL Classification: C11, C22, C51, E58, G21

Suggested Citation

Gross, Marco and Población García, Francisco Javier, A False Sense of Security in Applying Handpicked Equations for Stress Test Purposes (September 22, 2015). ECB Working Paper No. 1845, Available at SSRN: https://ssrn.com/abstract=2664133

Marco Gross (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Francisco Javier Población García

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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